An Experimental Economic Analysis of Carbon Trading Options for Australia

John Tisdell and Corinne GraingerAtmospheric Environment Research Centre

Griffith University Brisbane Australia

www.economicexperiments.com

Outline

• Background• Research questions• Experimental design and procedures• Experimental results• Conclusions and recommendations

Background

• Government reports: PM Task Force, Garnaut Review, Carbon Pollution Reduction Scheme• emissions trajectory, coverage, permit allocation, inter-temporality,

governance and compliance.

• Two main issues..– Inter-temporal flexibility

Futures and spot markets– Emissions trajectory

Low or high permit reductions

Inter-temporal flexibility

• In markets for pollution such as greenhouse gases, inter-

temporal flexibility plays a large role in ensuring market

success (Stavins 1998; Stern 2007).

Emissions trajectory

• The trajectory chosen to achieve the final level of stabilisation is of as much importance in determining the costs of mitigation, as the actual level of final stabilisation (Goulder and Mathai 2000; Grübler and Messner 1998; Jaffe et al. 1999,

2002; Manne and Richels 1997, 2004; Richels and Edmonds 1995; Schneider and Goulder 1997; Wigley et al. 1996)

6

Emissions Trajectory

• PM Task Force Report 2007 p.101

Research questions

1. Emissions trajectoryDoes the rate of decline in carbon permits impact on

compliance?

2. Inter-temporal flexibilityDo futures markets produce better results than simple spot

markets in terms of compliance and market activity?

Experimental design and procedures

High Reduction

(HR)

Low Reduction

(LR)

Spot Market

(SM)

4 sessions

10 periods

4 sessions

10 periods

Futures Market

(FM)

4 sessions

10 periods

4 sessions

10 periods

Experimental Environment• Players were informed that they were the producer of a fictitious good

and that they could produce this good up to a maximum production level. • They were provided with a simple production function and marginal value

for the good. They were also provided with a stock of carbon permits which declined over time.

• For each unit they produced they were required to hold a permit. • Players faced random auditing and if found to have less permits than their

production they would face a fine. • The aim was to maximise their earnings taking into account their earnings

from production, trade and any fines they may receive. • Instructions and Quiz: http://www.ens.gu.edu.au/Johnt/carbon_paper_1/

Computer Screens

Income Table

Future Trading Table

Experimental Parameters

Pd 1 2 3 4 5 6 7 8 9 10

Low 90 86 82 78 74 70 66 62 54 50

High 90 83 76 69 62 55 48 41 34 27

Player 1 2 3 4 5 6 7 8

Marginal Value 40 60 80 100 120 140 160 180

Modeled equilibrium prices and associated fines

Period 1 2 3 4 5 6 7 8 9 10

Low

Equilibrium Price 50 50 70 70 70 90 90 90 90 110

Penalty 125 125 175 175 175 225 225 225 225 275

High

Equilibrium Price 50 70 70 90 90 110 110 130 130 150

Penalty 125 175 175 225 225 275 275 325 325 375

Experimental results

• Level of Compliance – Differential between production and carbon permit

holdings

• Convergence– Market prices and quantities to CE

Convergence of market prices through rounds

0 1 2 3 4 5 6 7 8 9 10

-30.00

-20.00

-10.00

0.00

10.00

20.00

30.00

40.00

50.00Spot - Low reduction sessions: market price convergence

through rounds

session 1

session 2

session 3

Session 4

Round

Mar

ket P

rice

Diff

eren

tial

(obs

erve

d - m

odel

led)

0 1 2 3 4 5 6 7 8 9 10

-40.00

-20.00

0.00

20.00

40.00

60.00

80.00Spot - high reduction sessions: market price convergence

through rounds

session 1

session 2

session 3

Session 4

Round

0 1 2 3 4 5 6 7 8 9 10

-30.00

-20.00

-10.00

0.00

10.00

20.00

30.00

40.00

50.00Future - low reduction sessions: market price convergence

through rounds

session 1

session 2

session 3

session 4

Round

Mar

ket P

rice

Diff

eren

tial

(obs

erve

d - m

odel

led)

0 1 2 3 4 5 6 7 8 9 10

-30.00

-20.00

-10.00

0.00

10.00

20.00

30.00

40.00

50.00

60.00Future - high reduction sessions: market price convergence

through rounds

session 1

session 2

session 3

session 4

Round

Convergence of market quantities through rounds

0 1 2 3 4 5 6 7 8 9 10

-40

-20

0

20

40

60

80Spot - Low reduction sessions: market quantity convergence

through rounds

session 1

session 2

session 3

Session 4

Round

Mar

ket q

uanti

tydi

ffer

entia

l (o

bser

ved

- mod

elle

d)

0 1 2 3 4 5 6 7 8 9 10

-60

-40

-20

0

20

40

60

80Spot - high reduction sessions: market quantity

convergence through roundssession 1

session 2

session 3

Session 4

Round

0 1 2 3 4 5 6 7 8 9 10

-100-80-60-40-20

020406080

100Future - low reduction sessions: market price convergence

through roundssession 1

session 2

session 3

session 4

Round

Mar

ket q

uanti

ty d

iffer

entia

l (o

bser

ved

- mod

elle

d)

0 1 2 3 4 5 6 7 8 9 10

-80

-60

-40

-20

0

20

40

60Future - high reduction sessions: market quantity convergence

through roundssession 1

session 2

session 3

session 4

Round

Spot and Future Quantities

Mean

Quantity

Futures Market, Low

Reduction

Futures Market, High

Reduction

Round 7 8 9 10 7 8 9 10

Spot Qty 11.68 10.83 12.35 10.84 10.94 10.82 11.85 8.36

Forward Qty 6.67 11.38 11.50 7.92 2.00 5.00 7.00 6.70

p-value 0.250 0.891 0.815 0.366 0.000 0.000 0.442 0.522

Interaction of emission reductions and market form

Future volumes traded

Conclusions and recommendations• The policy implications of these results.. Based on

the experimental data:• If the authority is concerned with achieving an

emission target quickly, high rates of permit reduction with spot markets should be considered.

• Higher rates of reduction did not result in greater non-compliance.

• There should be high rates of compliance and limited need for futures markets during the initial phase.

• If a low emissions trajectory is adopted then it could be implemented with a futures market option.

• The findings of this work are based on experimentation.

• Experimental economic techniques are the glass houses of policy… Field trials are required before the new variety is released…

• Further research is required to explore operational and field specific implications.

•

• Key elements:– Reduce carbon pollution by 60 per cent of 2000 levels by 2050.– Unconditional 5 per cent reduction in carbon pollution below 2000 levels by

2020. Up to 15% depending on global agreement.– Use of market-based instruments– Assistance for households and business– Price cap

• The intention is to commence the scheme on 1 July 2010.

Carbon Pollution Reduction Scheme

• Coverage

Entities with direct emissions (stationary and transport) of 25 000 t co2-e per year or more.

Setting the cap

5 year caps with gateways (projections) to 10 years depending on international agreements Differences between the scheme cap and the national target will be reconciled through the

allocation of notional credits to firms and industries not covered by the scheme.

Definition and allocation of permits

Vintage permits defined in tones of carbon emission Administrative Allocations

• Emissions-intensive trade exposed industries (EITE)• Strongly affected industries

– Government auctions– Unlimited banking (exception: those issued under the price cap)– Short-term borrowing from following year (max 5%)

Framework

• Reporting and compliance Compliance requires surrender of one permit for each

tonne of carbon dioxide equivalent emitted Annual independent audit

National Greenhouse and Energy Reporting Act 2007. National greenhouse and Energy Reporting System -

http://www.nger.com.au

– EITE scheme• Emissions-intensive, trade exposed industries• 90% for activities that has at least 2000 t co2-e per million dollars of

revenue.• 60% for activities that have at least 1000 t co2-e per million dollars of

revenue.• 4 year evaluation – 1 July 04 to 31 December 08.

– strongly affected industries • Also includes strongly affected industries –coal fired electricity generation

1 July 04 to 30 June 07 >0.86 t co2-e/MWh. Due for review in 2013. • Assistance will be in the form of funding for carbon capture, storage

technology and sustainable coal. It will be delivered through existing schemes. (National Low Emissions Coal Initiative)

• Direct assistance in the form of administratively allocated permits (approx. $3.9 billion)

– Objective – avoid ‘carbon leakage’ – companies moving overseas as a result of carbon reduction requirements.

Administrative allocation

• Auction will be held 12 times through the financial year• Future vintage auctions – four years of vintages will be

advanced auctioned (current vintage plus advance auctions of three future vintages).

• Simultaneous ascending clock auctions• Price cap in 2010-2015 – price cap of $40 - unlimited store of

additional permits at the fixed price.• Effectively capping prices and imposing a static Pigovian tax

on any firm who can earn more than $40/Ct from production.

• All permits are tradeable except those issued under the price cap scheme

Government Auction